As contemplated by the Dodd-Frank Act, advisers that only manage venture capital funds will be exempt from the new registration requirements imposed upon private fund advisers under the Investment Advisers Act of 1940 (the Advisers Act).
These rules become mandatory for fund managers beginning in 2012, and in the coming days we will be covering the rules in a series of summaries on our venture capital blog The Venture Alley. This is the first summary in that series, outlining qualification under the new “venture capital fund” exemption from registration under the Advisers Act. Fund managers that manage only private funds that qualify for the venture capital fund exemption or a different exemption (such as the exemption for funds meeting the $150 million test, foreign private advisers or family offices) generally would not be required to register under the Advisers Act. Finally, even exempt advisers will be subject to some reporting requirements.
The final SEC rules define a “venture capital fund” as a private fund that satisfies the following five conditions:
- At least 80 percent "qualifying investments"
A venture capital fund can hold no more than 20 percent of the value of its capital commitments in non-qualifying investments (other than short-term holdings). For purposes of this rule, only bona-fide capital commitments that are expected to be called are considered.
For these purposes, qualifying investments means: (i) any equity security issued by a qualifying portfolio company that is directly acquired by the private fund from the company (directly acquired equity); (ii) any equity security issued by a qualifying portfolio company in exchange for directly acquired equity issued by the same qualifying portfolio company; and (iii) any equity security issued by a company of which a qualifying portfolio company is a majority-owned subsidiary, or a predecessor, and that is acquired by the fund in exchange for directly acquired equity.
Facilitation of reorganizations/recapitalizations. (ii) was added to facilitate portfolio company reorganizations or recapitalizations, where funds may elect or be required to trade existing securities for newly issued portfolio company securities, such as under a pay-to-play provision.
Facilitation of portfolio company acquisition using acquirer stock. (iii) is intended to facilitate acquisitions that include purchaser securities as part of the purchase price, enabling qualifying funds that may acquire such securities to treat them as qualifying even if they are public securities or otherwise would be non-qualifying.
Equity security includes common stock as well as preferred stock, warrants and other securities convertible into common stock in addition to limited partnership interests. Equity securities is broadly defined (using the definition under the Exchange Act) and would include bridge loans convertible on their terms into equity of the portfolio companies.
A qualifying portfolio company is defined as any company that:
is not a reporting or foreign traded company and does not have a control relationship with a reporting or foreign traded company
does not incur leverage in connection with the investment by the private fund and distribute the proceeds of any such borrowing to the private fund in exchange for the private fund investment, and
is not itself a fund (i.e., is an operating company)
Restriction on investments in publicly traded securities. Publicly traded companies are not qualifying portfolio companies, so direct investments in those companies generally must be done within the 20 percent non-qualifying basket (unless those shares are received as part of an acquisition of a qualifying portfolio company (as discuss above under the definition of equity security). Equity securities in a qualifying portfolio company that become publicly traded after acquisition will still be treated as qualifying securities.
Restriction on fund of fund investments. The SEC determined that Congress did not intend to include venture capital funds of funds within the venture capital fund exemption, so qualifying portfolio companies must be operating companies (rather than funds); however, for purposes of applying this rule, funds may disregard wholly owned intermediate holding companies formed solely for tax, legal or regulatory reasons (such as “blocker corporations” or other alternative investment vehicle structures occasionally used by fund managers to deal with such issues). Conversely, the use of holding companies cannot be used to circumvent these rules (e.g., acquiring equity securities in a holding company that itself makes nonqualifying investments if made by the fund directly).
Short-term holdings. A qualifying fund may also invest in cash and cash equivalents, US Treasuries with a remaining maturity of 60 days or less and shares of registered money market funds. The addition of registered money market funds is new in the final rules, based on comments. These short-term investments are treated as qualifying for purposes of, and not counted against a venture capital fund when, determining whether it satisfies the 20 percent limit for non-qualifying investments. For this reason, fund managers may want to conform their idle funds investment practices to these new restrictions. Fund advisers seeking to invest idle funds in longer-term or higher yield instruments must do so within the 20 percent non-qualifying basket.
- No fund borrowing (other than short-term and certain guarantees)
A “venture capital fund” generally cannot borrow, issue debt obligations, provide guarantees or otherwise incur leverage, in excess of 15 percent of the fund’s capital contributions and uncalled committed capital, and any such borrowing, indebtedness, guarantee (except as set forth below) or leverage is for a non-renewable term of no longer than 120 calendar days. The rule is designed to permit short term borrowings pending capital calls but funds must carefully review their terms to ensure they are consistent the foregoing rules. For funds managers with tax exempt or other UBTI sensitive investors, the short term borrowing restriction may already be a de-facto requirement. The SEC has also added an important exception to the guarantee restriction: venture capital funds may guarantee qualifying portfolio company obligations without having those guarantees charged against the 15 percent cap, provided that the guarantee does not exceed the venture capital fund’s investment in such company.
- No regular redemption rights given to investors/limited partners
A “venture capital fund” cannot offer its investors redemption or other similar liquidity rights except in extraordinary circumstances, but entitle investors generally to receive pro rata distributions. Whether or not specific redemption or opt out rights for certain categories of investors under certain circumstances should be treated as extraordinary will depend on the particular facts and circumstances. Presumably, typical side letter redemption rights or obligations triggered by changes in applicable law should continue to be permissible, but redemption rights that are not triggered by changes in applicable law will need to be reviewed more closely in the future to ensure that they do not rise beyond the level of extraordinary.
- Must pursue a venture capital strategy (and market accordingly)
A “venture capital fund” must represent itself as pursuing a venture capital strategy to its existing and prospective investors. Whether or not a fund represents itself as pursuing a venture capital strategy will depend on the facts and circumstances; however, per the SEC, this means that a venture capital fund manager seeking the venture capital fund exemption should not call the fund a hedge fund or multi-strategy fund and should not include the fund in hedge fund databases or indices. The SEC noted that a fund manager that represented to its investors that it is pursuing a venture capital fund strategy but that does not actually pursue such a strategy may have made an untrue statement of material fact in violation of the antifraud provisions of the Advisers Act, as to which the SEC would not need to prove scienter/intent. It does appear that venture capital will be broadly interpreted to include various private capital investment strategies including growth and international focused investments.
- Not registered under the Investment Company Act and not a business development company
“Venture capital funds” do not include funds registered under the Investment Company Act of 1940 or that have elected to be regulated as business development companies.
20 PERCENT NON-QUALIFYING INVESTMENT ALLOWANCE CALCULATIONS
Generally. Based on a number of comments, including comments of DLA Piper, the SEC has now included a 20 percent allowance for funds to use in making investments that would not qualify within the above rules, including activities such as acquiring funds on public markets, making debt investments, or otherwise. This should also allow funds some leeway in avoiding accidental violations of the rules.
Testing date and methodology. To determine whether a fund is within the 20 percent allowance, the percentage is be tested immediately following a non-qualifying investment. Significantly, the test does need not otherwise need be performed on a regular basis, so a fund may actually exceed the 20 percent on a valuation basis at certain times. Having nonqualifying securities in excess of this threshold does not violate the exemption but rather only precludes the venture capital fund from making a non-qualifying investment until the amount of non-qualifying investments (excluding any short-term holdings) within its portfolio is reduced to below 20 percent including the new non-qualifying investment.
Valuation to apply the 20 percent test. The 20 percent test is applied against the amount of fund capital, which includes called capital and unfunded capital commitments expected to be called. When a fund values its portfolio (both for its called capital and the amount of nonqualifying investments) for purposes of the 20 percent basket, it may do so either based on the historical cost or the fair value of those investments at the time the test is made; provided, however, that it must consistently apply either such method for the duration of the fund’s term (but presumably can vary methodologies between various venture capital funds). It seems likely that most fund managers will use cost rather than fair value; as the SEC notes, using historical value would avoid having to account for market fluctuations or other changes in portfolio value while the investments are held by the fund. Using a cost value is permissible, provided that the fund manager does not switch to fair value methods on some future date. Given market volatility in venture capital investing, we would anticipate that most venture capital funds will apply the cost methodology for purposes of these rules.
Changes in qualifying or non-qualifying character of investments. Notwithstanding that a fund should test its non-qualifying investment percentage at the time of each non-qualifying investment, a qualifying investment will not become non-qualifying simply because the underlying portfolio company is itself no longer qualified. For example, a qualifying investment in a company will not be altered simply because that company later files to become a public reporting company – even though the shares are holdings of public shares, if they were acquired a the time the company was a qualifying company, they will continue to be treated as a qualifying investment for subsequent 20 percent non-qualifying basket calculations.
Limited allowance for portfolio company founder liquidity in connection with investments. To the extent that a venture capital fund wants to provide founders of a portfolio company with some liquidity in connection with an investment (i.e., to acquire their shares directly), it would need to do so within the 20 percent non-conforming basket. Previously, the SEC had proposed a 20 percent allowance in this regard, but that was removed when the 20 percent basket was added.
Foreign fund advisers can use the venture capital fund exemption (if they otherwise qualify). The SEC clarified that a “venture capital fund” does not need to be managed by a US-based adviser and, accordingly, non-US-based advisers can also qualify for the exemption (in addition to other potentially available exemptions) if they are managing qualifying funds.
Secondary market transactions must be done under the 20 percent non-qualifying basket. Previously, the SEC had proposed an allowance for secondary market transactions; however, with the implementation of the 20 percent non-qualifying basket, the rules require all such transactions to fit within that basket. This could create challenges in valuations when calculating the 20 percent threshold, as addressed above, particularly if securities acquired on secondary or public markets appreciate significantly.
No management requirement. The SEC has removed any requirement that a fund provide managerial assistance to portfolio companies, acknowledging that the business arrangement should control such decisions and that, ultimately, the requirement could be unnecessarily prescriptive without creating benefits for investors.
The rules grandfather any pre-existing private fund as a venture capital fund if it satisfies the following three conditions:
- Represented to investors and potential investors at the time the fund offered its securities that it pursues a venture capital strategy
- Has sold securities to one or more investors prior to December 31, 2010
- Does not sell any securities to, including accepting any capital commitments from, any person after July 21, 2011. The calling of capital after July 21, 2011 is allowed as long as the commitment took place before that date.
Despite comments urging the SEC to revise these rules to be more expansive, the SEC declined to increase the scope of the grandfathering provision, other than to clarify that the fund must have held itself out as pursuing a venture capital strategy (previously, the SEC had proposed that the fund must have held itself out as a venture capital fund). Accordingly, per the SEC, a fund that seeks to qualify under the grandfathering rule should examine all of the statements and representations made to investors and prospective investors to determine whether the fund has satisfied the “holding out” criterion. For funds that had their initial closing in 2011 or that will have their final closing after July 21, 2011, the grandfathering rules will not apply and the fund will otherwise need to qualify under the new venture capital fund definition or under a different exemption.
Coming soon will be our next posts about these new rules:
- Private fund advisers exemption (having less than $150 million in assets under management)
- Foreign private adviser and family office exemptions
- Reporting requirements of exempt fund managers and related rules
We will keep you informed as these posts appear.
For additional resources and to see updates on this same issue, please visit The Venture Alley.
You may also enjoy our library of reports on breaking developments around Dodd-Frank.
This article was prepared with the assistance of Stephen Hsieh.